- With the economic outlook uncertain, the Fed appears poised to cut rates in 2019.
- The flat yield curve reconfirms that the U.S. economy is late cycle.
- Investors should prepare for rising market volatility and consider holding a high-quality fixed income portfolio.
- High yield has fared well, but has led to elevated valuations.
Remember when equity markets were skidding and the Federal Reserve was fearlessly hiking rates every quarter? That was just six months ago. So much has changed in such a short time.
Trade tensions have escalated, geopolitical risks have been rising and an increasing number of signals indicate the global economy could be losing steam. The Fed has responded with a dramatic turn in its policy, leading to a sharp rally in interest rates.
The benchmark 10-year Treasury yield dipped 72 basis points from its 2.79% peak in January to a low of 2.07% in early June. Market expectations now indicate interest rate cuts are coming. While trade disputes have dominated headlines, economic data has been weaker across the U.S., Europe and China. Industrial production has declined in China, falling to a 17-year low in early 2019.
Why the Fed pivot?
Just a year ago, the Fed appeared prepared to hike the fed funds rate well into 3% territory. But when equity volatility spiked in late 2018, monetary policymakers quickly changed their tune. The market expects the 2.5% fed funds rate established last year to be the peak for this cycle. What do we expect?
“It wasn't that long ago that the Fed was talking about three to four hikes in 2019, and now the market's pricing in two cuts in each of the next two years,” explains Mike Gitlin, head of fixed income at Capital Group.
The Fed’s dovish stance has spurred a broad-based rally across equities and credit assets. Central banks look to be taking a more aggressive tone on fighting against the next downturn, rather than merely accepting the inevitable.